Wall Street eyes 2004 for possible industry recovery

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Is the proverbial light many of us claim to see at the end of the tunnel really the end of the tunnel, or is it actually an oncoming train? This was the topic of discussion when a trio of Wall Street analysts and a venture capitalist gathered at September's National Fiber Optic Engineers Conference (NFOEC) in Dallas to share their perspectives on an industry recovery and field some difficult and often painful questions.

Has the old paradigm of sustained growth—in which the telecommunications industry outperformed the gross domestic product (GDP)—been played out? Moreover, do the recent market changes, including economic weakness, excessive debt load in some cases, the dislocation caused by the Telecommunications Act of 1996, and the Internet/capital boom, then bust, indicate a deeper industry malaise?

Powerful long-run growth factors are ebbing, according to Adam Quinton, co-head of telecom services research at Merrill Lynch. Revenue grew faster than the GDP during the boom years between 1991 and 2001 thanks to an ever-increasing number of access lines, second lines, and value-added services. This year, access lines in the United States have declined for the first time since the Great Depression.

Quinton also blames what he calls the "new new-thing hiatus" or the "killer-app vacuum." There is no new application big enough to boost service providers in any material way, he says.

Nikos Theodosopoulos, telecom equipment analyst with UBS Warburg's US Equity Research division, characterizes a killer app as a bandwidth-creating service that will either make someone money or save someone money. The 1990s were an aberration, he explains, because two killer apps had emerged—wireless technology and the Internet—and coupled with a virtually unlimited access to capital, which in the long run only made matters worse.

Now we need a new killer app, he contends, though it's anyone's guess what this technology may be. Back in 1993, even Bill Gates thought the Internet was just a fad; interactive TV to the home was considered the can't miss market.

According to Quinton, an unusual number of revenue deflationary factors have also altered the industry paradigm, including wireless substitution, Internet for voice, broadband for second lines, fat pipes for thin pipes, and cable for traditional telecom. Throw in regulatory intervention, he says, and the service-provider industry is in rough shape. AT&T, for example, saw revenue of roughly $15 billion in 2001, but that total has declined by a full quarter this year alone.

So what does this mean for equipment vendors? UBS Warburg's Theodosopoulos predicts:

  • U.S. carrier spending will decline 39% in 2002 and 5% in 2003.
  • Global carrier spending will drop 24% in 2002 and 4% in 2003.
  • Global telecom equipment revenues will fall 32% in 2002 and 3% in 2003.

And these are the best-case scenarios, he believes; the 2003 forecasts could drop an additional 10-20%. Moreover, he says, the decline in telecom equipment sales will most likely lead to industry consolidation.

Krish Prabhu, venture partner at Morgenthaler Ventures, maintains that the fundamental problem in the industry is not a lack of demand; it's the plethora of players. Too much money has come into the market, and too many players have emerged. Between 1995 and 2000, 15,000 new companies were created. Ten percent of these companies have been acquired, 10% have been shut down, and 8% have filed an initial public offering, all of which still leaves a huge number of companies vying for limited business opportunities.

The consolidation of market players has not yet happened, because many companies still have cash on hand. Though they may have been able to ride it out thus far, after another down year that cash will drain and those companies will not be able to raise more money, says Prabhu. The profit margins are not high enough to support so many players; the math, he says, just doesn't work.

Theodosopoulos admits there are a few factors that could alter his best-case forecasts for the better, though none of these factors is likely to occur. Regulation, he says, is a "massive wildcard," but change is typically too slow to affect the near-term outlook. Operators might start buying into sales proposals that purchasing next-generation equipment will lower their operating expenditures, but again, that's not likely to happen until 2004 at the earliest, he surmises.

The emergence of a new killer app could also improve the forecast. But, says Theodosopoulos, don't look to the existing operators to develop it. Entrepreneurs will likely lead the charge. The carriers' lack of confidence in startups is only a temporary roadblock, adds Prabhu. When the need to introduce new technology is dire, the carriers will look to the startups.

Theodosopoulos agrees, adding that the large equipment companies will move toward new services. As big systems companies downsize, opportunities will emerge for niche players—with additional opportunities coming in the form of partnerships in which both the startups and the incumbents benefit.

Morgenthaler's Prabhu, former chief operating officer of Alcatel and chief executive of Alcatel USA, remains bullish despite the current market woes. In 2000, he says, industry analysts predicted the good times would continue, and they didn't. Now they say the market will remain in the doldrums, which, he jokes, leads him to believe a recovery is imminent.

All joking aside, Prabhu acknowledges that this is the worst of times for the telecom market. The industry has seen a net loss in market capital of nearly $2 trillion and a net loss of 600,000 jobs. The amount of debt restructured is roughly $600 million, and private investment is down by a factor of 10.

That said, however, it's also the best of times, he believes. The industry is improving performance 100% each year, and Internet traffic continues to jump nearly 80% per year. Prabhu also sites the availability of skilled resources on a global basis. A dollar invested today will buy you more, he says.

So there is bad news and good news. While the panelists agree there will be no new builds in 2003, they also agree that the recovery is likely to begin in early 2004. And look for next-generation metro SONET to show the first signs of life.

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